Box A: Stress tests of the New Zealand banking system

Stress testing is a tool to assess the resilience
of financial institutions to a hypothetical adverse event,
usually a severe but plausible economic downturn.
Introducing a comprehensive stress testing framework
for the New Zealand banking system is a strategic
priority for the Reserve Bank, and this is discussed in
more detail in chapter 6.

During this year, the Reserve Bank and the
Australian Prudential Regulation Authority (APRA)
collaborated on stress tests that included the four
subsidiaries of the major Australian banks. The Reserve
Bank also conducted a smaller exercise with the five
domestically owned banks.1

The major bank stress testing exercise
featured two adverse economic scenarios over a five
year time period. In scenario A, a sharp slowdown in
economic growth in China triggers a severe double-dip
recession. Real GDP declines by around 4 percent, and
unemployment peaks at just over 13 percent. House
prices decline by 40 percent nationally, with a more
marked fall in Auckland. The agricultural sector is also
impacted by a combination of a 40 percent fall in land
prices and a 33 percent fall in commodity prices. The
decline in commodity prices results in Fonterra payouts
of just over $5 per kilogram of milk solids (kg/MS)
throughout the scenario.

Scenario B features a significant increase in
interest rates. Initially this is due to a stronger-than expected
economic recovery. However, from the second
year of the scenario there is a material slowing in global
economic growth accompanying a severe disruption
to global oil production. The consequent inflation
pressures delay monetary policy easing, despite a
domestic recession, a 30 percent fall in house prices and
unemployment of just under 12 percent. Rising global
bank funding costs increase lending rates by a further
200 basis points, accentuating tight monetary policy and resulting in floating mortgage rates peaking at 11-12
percent. Fonterra payouts fall to around $6 kg/MS from
the second year.

These scenarios were intended to be severe
but plausible, and in the case of scenario A, broadly
matched the experience of some of the more severely
affected economies in the GFC.

The stress test was conducted over two phases.
In phase one, banks were asked to provide estimates
of credit losses, based off their own internal stress
testing models. Results in this stage were subject to a
high degree of variability due to differences in modelling
approaches between banks. In the second phase, banks
were supplied with common credit loss estimates, which
were estimated on the basis of Reserve Bank and APRA
stress testing models, international experience during
similar scenarios, and bank responses from phase one.
In both of these phases, banks were initially asked to
model the effects of these scenarios on balance sheets
and profitability without assuming any management
actions to mitigate their impact.

The most significant effect of the scenarios was
to generate a large increase in loan losses, with impaired
asset expenses peaking at 1.3 and 1.5 percent of assets,
respectively, in the two scenarios in phase two (figure
A1). Higher credit losses, combined with a decline in net
interest income due to increased costs for bank funding,
resulted in a significant decline in bank profitability.
However, reflecting strong underlying earnings in the
New Zealand banking system, these factors were only
sufficient to cause negative profitability in a single year
in each scenario (figure A2).

Figure A1: Impaired asset expenses (percent of gross loans)

Source: RBNZ.

Figure A2: Return on assets

Source: RBNZ.

While positive average profitability meant that
banks were able to conserve capital levels, deteriorating
asset quality resulted in an increase in the average risk
weight of exposures, causing a decline in regulatory
capital ratios. Common equity Tier 1 (CET1) capital
ratios declined by around 3 percentage points to a trough
of just under 8 percent in each scenario, but remained
well above the regulatory minimum of 4.5 percent (figure
A3). Banks are also required to maintain a 2.5 percent conservation buffer above all minimum regulatory capital
requirements, or else face restrictions on dividends. On
average the banking system fell within this buffer ratio in
both scenarios, due to total capital ratios falling close to
minimum requirements (figure A4). Average buffer ratios
reached a low of 1 percent in both scenarios. As a result,
some banks would have been faced with restrictions
on their ability to issue dividends. The intention of the
buffer ratio is to provide a layer of capital that can readily
absorb losses during a period of severe stress without
undermining the ongoing viability of the bank. Given
the severity of the scenarios, capital falling within buffer
ratios was an expected outcome.

Figure A3: CET1 capital ratios (percent of risk-weighted assets)

Source: RBNZ.

Figure A4: Total capital ratios (percent of risk-weighted assets)

Source: RBNZ.

Faced with a scenario of this magnitude, banks’
management would be expected to undertake a number
of actions to restore capital buffers. A second part of
phase two involved banks outlining these management
responses and to model their effects. For most banks,
the key response was to significantly reduce new lending
to reduce risk weighted assets and increase regulatory
capital ratios. Some deleveraging is to be expected in
a severe recession, especially on corporate exposures
where defaulted assets will generally not be replaced.
However, continued supply of new lending is essential
to prevent markets from becoming disorderly and to
allow banks to resolve defaults by selling foreclosed assets to new owners. The proposed average reduction
in exposures of around 10 percent in each scenario
was large, and may have resulted in significantly worse
macroeconomic and credit loss outcomes.

Most banks also report that they would reduce
costs by cutting bonuses, reducing staff numbers and
lowering discretionary expenditure. Some banks also
reported measures to re-price credit to recoup margins,
while one bank reported a capital injection from their
parent.

The result of these mitigating actions is to
return the banking system to profitability in all years of
the scenarios, and to boost CET1 capital ratios to 9.5
percent at the low point of each scenario. International
experience suggests that it can often be difficult to
implement significant mitigating actions in the midst of
a severe crisis. Therefore, in interpreting results, the
Reserve Bank’s emphasis tends to be on ensuring that
banks have sufficient capital to absorb credit losses
before mitigating actions are taken into account. The results of this stress test are reassuring, as they suggest
that New Zealand banks would remain resilient, even in
the face of a very severe macroeconomic downturn.

The Reserve Bank also engaged the five
domestically owned banks in a basic credit stress test
in April this year. This test assessed the balance sheet
resilience of these banks to a large increase in credit
losses due to a severe domestic recession and large
falls in asset prices. All participating banks appear to
be resilient to a major downturn of this nature, with no
bank breaching minimum capital requirements. This test
was designed as an introduction to stress testing and is
part of a multi-stage process to enhance stress testing
capacity at these banks.

The Reserve Bank views stress testing as an
important component of sound risk management within
banks. The banks are expected to continue to develop
their stress testing frameworks, and to use the results to
inform their capital management and risk appetite setting
processes.